Risk Transfer

The transfer and sharing of project risks is considered by many as one of the main benefits of PPPs. Much of the risk associated with the design, construction, financing, operations, and maintenance of transportation projects is traditionally managed by the government. In contrast, a PPP seeks to allocate risks to the parties best able to manage them (Bettignies and Ross 2004; U.S.DOT 2004). Three factors drive risk sharing in PPPs. First, the private sector is in charge of a number of activities during the lifetime of the project, including financing, whereas the government usually holds a residual ownership right. Second, the two contracting parties in a PPP arrangement have different stakeholders and different objectives, risk perceptions, and constraints. Third, the public and private partners may have different abilities to diversify the risk (Checherita and Gifford 2008). For example, the private partner can diversify the risks of construction and financing across many projects.

Concern about how this risk allocation is handled was borne out by the two surveys done for this synthesis. Risk sharing and allocation among public and private sectors on PPPs is considered as an either "very important" or "somewhat important" concern by all respondents in our state DOT survey, with 88% responding that it is a "very important" concern. Also, most U.S. states and Canadian provinces that have completed or are currently are negotiating a PPP project use risk assessments when considering PPP proposals.

One of the respondents to our interested parties' survey identified the need for strong demarcation of responsibilities between the public and private sectors. In the survey, the Central Artery/Tunnel project in Boston (also known as the "Big Dig") was cited as an example of a project where there was a "too cozy" relationship between the public and private sectors leading to lack of oversight and enforcement of public interests. The Big Dig included a design and construction management contract with a joint venture between two large engineering firms, where considerable independent responsibility was handed over to the private sector. Another survey respondent indicated that the public sector may be unaware of what risks are being transferred and which ones remain.

The FHWA's PPP website (2008) and Table 2 in chapter two show a continuum of public/private mixes in order from those of greatest public responsibility to those of greatest private responsibility. The amount of risk allocated to each party depends on the type of partnership, the risk profile of each partner, and details specified in the partnership contract. Allocation of risks among private and public partners has been reviewed extensively in the literature (Fishbein and Babbar 1996; FHWA 2004; AECOM 2007b; Checherita and Gifford 2008). Checherita and Gifford (2008) provide a comprehensive typology of risks and identify risks most likely to arise under a PPP arrangement rather than under traditional financing or complete privatization. Risks are classified in three broad categories: (1) fiscal risks, (2) residual value or valuation risks; and (3) bidding risks. AECOM (2007b) provides discussion of risks, as summarized here:

• Public acceptance-Degree of public acceptance of the project, its procurement as a PPP, and the means by which the project will be paid (e.g., tolling).

• Control of assets-Perceived loss of control, particularly the level and frequency of toll rate increases, physical condition and appearance of the facility, and protection of the public interest.

• Protectionism-Concern about nationality of firms comprising the PPP team, which may result in legislative efforts to limit foreign involvement or state/local political and public grassroots efforts to oppose PPP with significant foreign company involvement.

• Political stability-Continuity of political support for a PPP project should there be a change in political structure or composition.

• Moral hazard-Public sponsor to avoid conflict of interests and fraudulent activities during procurement and execution phases of the project. Public sector to hold PPP provider publicly accountable for proper execution of the project consistent with the terms of the contract agreement.

• Demand/volume-Level and timing of traffic.

• Revenue-Level and timing of proceeds from tolls or congestion pricing of highway use.

• Environmental/archeological-Site conditions that may require mitigation, and the cost of mitigation measures and their responsibility.

• Right-of-way costs-Uncertainty in cost of acquiring parcels of land needed for project.

• Construction costs-Impacts from availability and cost of materials, labor, and maintenance of traffic, plus the cost of surety bonds.

• Maintenance costs-Cost of maintenance and repair activities that may be affected by factors such as quality of design and construction, and changes in traffic volumes, among others.

• Liability/latent defectPotential for defects in design or construction, and the effect on project costs and the responsibility for paying these costs.

• Life-cycle costs-Cumulative costs of facility maintenance, rehabilitation, and reconstruction/expansion over the term of the contract and its effect on cash flow and
reserves.

• Regulatory/contractual-Changes in regulation or contract provisions that affect the cost exposure of one or more partners.

• Payment structure/mechanism-Effect on value of project participation based on source, method, and timing of project cost reimbursement or availability payment.

• Transaction costs-Level of costs associated with completing various transactions involved in completing the PPP contract agreement and responsibility for payment of these costs.

• Changes of law-New statutes and regulations, including design/construction standards, which affect the cost of the project and delivery schedule.

• Compensation/termination-How PPP team will be compensated for work completed if contract is terminated, depending on reasons for termination, and any penalties for early termination by the sponsoring agency.

• Economic shifts-Changes in economic activity and demography of the region that could affect traffic and revenue over the term of the contract.

• Currency/foreign exchange-Changes in relative value of national currencies that can affect the cost of the project and value of revenue to a PPP provider based on another country with different currency used for project reimbursement or payment of revenue proceeds.

• Taxation constraints-National, state, or local taxes on the materials used in developing the transportation facility and the proceeds from operation of a priced facility that can affect financial viability.

AECOM (2007b) also provides a detailed table summarizing risks fully or partially transferred to the private sector based on 17 types of alternative PPP approaches, as shown in Table 3. For instance, in a DBFO agreement, finance, design, construction, construction inspection, maintenance, operations, and traffic-revenue risk are often transferred to the private sector.

In a PPP, risk should be allocated to the party that can best manage such risk. According to a 2008 GAO study, some of the typical risks transferred to the private sector include project construction/schedule risks and traffic/revenue risks. The GAO report noted international examples that show the benefits of transferring the aforementioned risks to the private sector. One such project was the CityLink highway project in Melbourne, Australia, which was subject to extensive delays and additional costs. Because all construction risks had been transferred to the private sector, none of the additional costs of this project were a responsibility of the public sector. An example of the benefits of transferring traffic and revenue risks cited in the GAO report is the Cross City Tunnel in Sydney, Australia, where public officials have indicated that the public sector has not been affected (financially) by the low traffic and revenues, because those risks were borne by the private sector. The project was sold in 2007 to new private owners, after the first concession failed.

TABLE 3
RISK TRANSFER RESPONSIBILITIES UNDER DIFFERENT PPP ARRANGEMENTS

aFunctional Responsibilities and Project Risks noted with a check mark ( ) may be transferred in whole to the private partner or shared with the public sponsor, depending on the contract.

bRefers to long-term risk of asset failure or physical obsolescence.

cRefers to private developer portion of infrastructure.

Source: FHWA Office of Policy and Governmental Affairs, ìUser G uidebook on Implementing Public Private Partnerships for Transportation Infrastructure in the United States,” prepared by AECOM, July 2007.

The original Pocahontas Parkway project, on the other hand, is an example of what some might consider poor risk allocation on the part of the public sector. Under the original PPP agreement, the Virginia DOT would operate and maintain the facility, thus retaining some of the traffic and revenue risk by providing funding to cover operations and maintenance (O&M) until the facility generated sufficient toll revenue to meet its debt obligations, fully cover O&M expenses, and pay back the state's investment [including both capital (State Infrastructure Bank loan) and O&M]. Actual traffic was much lower than projections, and revenues were not sufficient to pay back debt (with bond holders bearing this risk); therefore, the state paid for O&M expenses on the facility until it was leased in 2006.

Some of the risks that are better managed by the public sector include environmental, right-of-way acquisition, statutory/ regulatory, and public acceptance risks (AECOM 2007b). The environmental process can be lengthy, especially if federal funding is involved, and can add significantly to the project cost (GAO 2000b). The South Bay Expressway in California is a good example of the environmental risk and uncertainty: it took almost a decade after the project had been awarded to a private partner to get environmental clearance (AECOM 2007b; GAO 2000b). The delay resulted in increased construction costs and foregone toll revenues. The original private partners sold the franchise to Macquarie Infrastructure Group in 2003, and shortly after construction of the facility began (AECOM 2007b).

Risks are not always fully transferred from one entity to another. For example, some PPP arrangements include traffic/ revenue risk sharing and/or include mechanisms that help mitigate the traffic risk to the private sector (Izquierdo and Vassallo 2004). Minimum revenue guarantees (Chile) or economic rebalancing provisions (Spain) are used to mitigate this risk. In the case of minimum revenue guarantees, the concession contract also includes revenue sharing if traffic exceeds projections, such that the public sector also benefits from additional revenues. Rebalancing provisions allow for revision of toll rates or changes in the length of the concession if a chosen metric (e.g., traffic, revenues) falls outside a specified range.